DOW TIPPING OVER?
by George Kleinman
Editor, Commodities Trends
June 25, 2007

On Friday, after the most anticipated initial public offering of the year (IPO), shares of Blackstone Group closed at $35.06, a 13 percent increase above the $31 offering price. On a day the Dow Jones Industrial Average dropped 185 points, Blackstone's debut could have been worse, but it still wasn't all that exciting for an offering that was seven times oversubscribed.

Blackstone Group is essentially a big hedge fund. Those of you who believe hedge funds are no-lose propositions for the ultra-rich should note a non-related story: Bear Stearns announced Friday it will pony up $3.2 billion to bail out a struggling hedge fund it manages.

I’ve noticed a flood of IPOs lately. IPOs can be lucrative for investors at the right time in the business cycle, but they also seem to proliferate at market tops. This is the primary tool insiders use to cash out of their companies. In effect, company insiders transfer their ownership to public investors who, in some cases, are left holding the bag.

During the dot-com bubble of the late 1990s, IPOs were out of control. IPO prices would generally spiral higher, but scores of those initial highfliers are now gone. Numerous founders and venture capitalists have now retired; the public has been left holding the bag. It’s also no coincidence one of the hottest IPO markets occurred in 1929--just prior to the Great Crash.

I don’t believe we’re in that phase of the business cycle where the stock market is going to continue stair-stepping higher, at least not until after there’s a healthy correction. Interest rates are moving higher, energy prices are surging, subprime loans are failing, housing prices are falling, and the consumer is deep in debt. The Dow is starting to show signs of tipping over.

What are these signs? Let’s take a look at a few major historical tops for the Dow. (Many show amazing similarities.)

In 2001, months before Sept. 11, the Dow had already topped during the May-June period of that year. Here’s what it looked like graphically:

2001 Dow

Source: Commodity.com

In May-June 2001, the market formed what is termed a “head-and-shoulders top”--a new high for the move, a first break, then a test of that high that fails below the high. When the market breaks below the low of the first break (under the “neckline,” the maroon line on the chart), the big break begins. Call that maroon line "support" or the dike; when the dike gives way, the floodgates are open.

Let’s take a look at some other major Dow tops.

1994 Dow

Source: Commodity.com

1987 Dow

Source: Commodity.com

In all three cases, once the Dow was unable to make a new high after the first break and then failed under the low of the first major correction, the dike broke and the oncoming flood washed out the speculative excess.

Now take a look at today’s chart of the Dow.

2007 Dow

Source: Commodity.com

Note the pattern is possibly setting up now but isn't complete. The Dow recently registered an all-time high on June 4 at 13,690. It then had what could be the “first break” to 13,251 on June 8; a test of the high that (thus far) appears to have failed. The support area, the dike, comes in at 13,278. A break and close below this level appears to have the potential to open the floodgates for an eventual washout, possibly down more than 1,000 points to approximately 12,000.

How To Play This

The September Dow mini futures contract (listed on the Chicago Board of Trade) is currently trading at approximately a 150-point premium to the Dow itself. A break of the support on the Dow equates to approximately 13,425 on the September futures. Should the market break and close under this level, consider a short sale for the Dow mini futures.

This can be considered a speculation or alternatively a hedge for a stock portfolio. I'd risk up to 150 points (a risk of approximately $750 per contract traded plus fees). If the futures drop 1,000 points, the profit potential is $5,000 per contract traded.

This is a higher-potential, higher-risk strategy and not appropriate for all investors. Only risk capital (money you can afford to lose) should be utilized for this strategy.

© 2007 George Kleinman
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